Jonathan Rogers, IFR Chief Analyst
WE RECALL THE New Testament parable warning against putting new wine into old bottles: “And no man putteth new wine into old bottles; else the new wine will burst the bottles, and be spilled, and the bottles shall perish.” I wonder how this applies to post-election Japan and Asia’s capital markets, and, moreover, to the capital markets in the rest of the world.
Japan’s newly elected prime minister, Shinzo Abe, strikes me as the epitome of new wine going into an old bottle and I suspect that – ignoring jokes about his age and the fact that he has been (an ineffective) prime minister of Japan before – the weak yen policy he is advocating is going to uncork one of the most notorious old bottles: the yen carry trade.
Borrowing at the ultra-low interest rates available on yen loans and reinvesting the proceeds in higher-yielding assets in anticipation of heavy gains – from the interest differential and from the depreciation of the borrowed currency – was one of the biggest games in town in the first half of the last decade. I suspect it’s about to make a comeback.
Readers of this column are aware that I believe Asia’s offshore primary debt market is a growing bubble that will eventually burst with painful consequences for most of those involved. But Mr Abe’s success in pushing down the value of the yen versus the dollar (the Japanese unit has shed 12% since his December election victory), and his unremitting rhetoric about the need to devalue it further to push the Japanese economy out of its prolonged funk, have surely brought the yen carriers out of hibernation.
So, as well as record low yields, über-cash-rich real money and manic rebated-up-to-the-hilt private banks, we now have Mr Abe’s shiny loafer on the foot pump, inflating Asia’s debt bubble with the carry trade he has unwittingly released on the region. The key question is how long that trade will remain on the books.
AT THE LOW yields that now prevail on US dollar bonds, the yield carry element is pretty negligible, at least in investment-grade. But if you were to buy a high-yield bond with a view to booking the coupons for a year or two and chuck in the kind of depreciation being called for on the yen, you could end up with something resembling an equity return.
It’s an utterly irresistible trade for those who have access to yen funding, and are desperately searching for ways to make a decent return in the fixed income markets – and this trade has barely even begun.
We now have Mr Abe’s shiny loafer on the foot pump, inflating Asia’s debt bubble
As to how much might be made on the currency depreciation leg of the carry trade, it’s worth taking on board the views of Goldman Sachs Asset Management supremo Jim O’Neill when it comes to the future direction of the yen.
Using the somewhat clunky Goldman Sachs Dynamic Equilibrium Exchange Rate, which O’Neill derived from the work of academic economist John Williamson, fair value for the yen dollar rate is somewhere around the ¥105 mark against the dollar.
But if you add in the possibility that Mr Abe is serious about targeting a 2% inflation rate for Japan, then the GSEER puts fair value for the yen/dollar exchange rate at an eye-popping ¥155 or so. That is derived hypothetically from a starting point of 1990 and assumes that the 2% inflation rate had been achieved over that period.
No one yet knows whether 2% inflation will be a core policy aim for the Abe administration, nor whether that inflation rate will be achieved if it does prove to be a goal. But ¥155 would really be something for the yen carriers to get their teeth into as a target and the carry trade would be put on in truly Biblical proportions.
BACK IN THE heady days of 2007, it was estimated that around US$1trn-equivalent of debt was locked into yen funded carry trades, and although in-depth data is not available, I would bet that a fair amount of that was invested in US mortgage-backed securities. We all know what happened when that sector went sour, yen carry trade or no.
I speculated in this column last week that the US debt ceiling quagmire might send yields higher in the Asian primary debt markets, at least in the medium term. The one input that might mitigate that risk, however, is liquidity.
Judging by the tens of billions of dollars that have been thrown at Asia’s primary market so far in this still-young month, there’s no shortage of the stuff. The reinstatement of the yen carry trade will only add more fuel to the fire.
Perhaps the real-money bid already contains a critical mass of yen-funded leverage, but there will be more to come unless Abe makes a U-turn on the yen – something I doubt a late-career politician who has staked his entire reputation on the matter is likely to do.
All this means another major market imbalance is brewing, and while it might feel fine and dandy as it helps to pump the Asian debt market bubble to ever more excessive levels, the yen carry trade will eventually be unwound once it has delivered the requisite returns. All things being equal, that will surely be the moment the bubble is popped – or, to put it another way, the old bottle is burst.
